Market based and interventionist supply side policies

Introduction

So far you will have covered the impact of government intervention on aggregate demand levels and your classes should now have an understanding of some of the arguments for and against the use of government stimulus measures. This is a good time to stress that while all economists accept that fiscal stimulus measures will increase economic activity in the short term, economists disagree about the merits of such a practise long term. The central plank of this argument revolves around the level of 'crowding out' that will occur in an economy. It is a reasonable assumption that any fiscal stimulus package will cause a degree of crowding out as the price of production factors increases. However it is the degree to which public spending crowds out private investment that will determine the effectiveness of any stimulus package. This lesson will focus on government intervention in aggregate supply - something that all economists would agree can bring about long term benefits to an economy but also considers how such a policy should be funded - through the private sector or through government spending.

Enquiry question

What are supply side policies and how do they play a role in maintaining a modern successful economy?

Lesson time: 80 minutes

Lesson objectives:

Explain how investment in a nation's factors of production can bring about a short-term impact on aggregate demand, but more importantly will increase LRAS. Examples include investment in education and training which will raise the levels of human capital, encouraging research and development and improvements to infrastructure.

Explain that targeting specific industries through policies including tax cuts, tax allowances and subsidized lending promotes growth in key areas of the economy and will have a short-term impact on aggregate demand but, more importantly, will increase LRAS.

Explain how factors including deregulation, privatization, trade liberalization and anti-monopoly regulation can be used to encourage competition.

Explain how factors including reducing the power of labour unions, reducing unemployment benefits and abolishing minimum wages can be used to make the labour market more flexible (more responsive to supply and demand).

Explain how factors including personal income tax cuts can be used to increase the incentive to work, and how cuts in business tax and capital gains tax are used to increase the incentive to invest.

Evaluate the effectiveness of supply-side policies through consideration of factors including time lags, the ability to create employment, the ability to reduce inflationary pressure, the impact on economic growth, the impact on the government budget, the effect on equity, and the effect on the environment.

Teacher notes:

1. Beginning activity - begin with the opening question and then discuss this as a class. (Allow 10 minutes in total)

2. Processes - technical vocabulary - the students can learn the background information from the opening video, the first three activities on this page and the list of key terms. Allow 30 minutes for the both activities.

3. Applying the theory - activities 4 and 5 apply the theory to two nations suffering from low productivity - UK and Spain (15 minutes)

4. Developing the theory - activity 6 and 7 develop the theory through a question of what makes some nations richer than others and a TOK link on whether the public or private sectors should provide education and training. (15 minutes)

5. Final reflection - activity 8 contains a paper one style examination question which could also be used as a class or homework exercise. (10 minutes)

Key terms:

Supply side policies - policies aimed at increasing aggregate supply (AS), a shift from left to right. They enhance the productive capacities of an economy while improving the quality and quantity of the four factors of production. Successful policies can lower the natural rate of unemployment and can contribute to long-term economic growth without increasing the rate of inflation.

Market based supply side policies - market based supply side policies aim to increase the growth of AS by placing a greater emphasis on market forces and competition.

Interventionist supply side policies - interventionist policies aim to increase the growth of AS by placing a greater emphasis on greater intervention by governments.

Infrastructure - consists of any large scale capital used in the production of goods and services. When the government increases the infrastructure base of the country it also increases the production capacity (long run aggregate supply) of the economy.

Human capital - policies aimed at improving the quantity and or quality of labour through improvements in education and health.

The objectives of supply-side policies:

Key concepts to focus on are incentives, enterprise, technology, mobility, flexibility and efficiency.

1. Improve incentives to look for work and invest in people’s skills

2 .Increase labour and capital productivity

3. Increase occupational and geographical mobility of labour to help reduce the rate of unemployment

4. Increase investment and research and development spending

5. Promoting more competition and stimulate a faster pace of invention and innovation to improve competitiveness

6. Provide a platform for a sustained improvement in non-inflationary GDP growth

7. Encourage the start-up and expansion of new businesses / enterprises especially those with export potential.

The activities on this page are available as a PDF at: Government intervention and market policies

Beginning question

Outline which supply side interventionist measures your government has taken over a period of time, ideally 5 years or the length of the government. Discuss the merits and problems of such an intervention? Focus on the following areas: education, including adult training; infrastructure projects; taxation policy and help for new businesses.

Hint:

Responses should also focus on the opportunity cost of infrastructure and spending projects.

Activity 1: Market and interventionist supply side policies

Watch the following short video and then answer the questions that follow:

(a) Explain some of the benefits that supply side policies can bring to an economy?

The video identifies higher economic growth through rises in individual or collective productivity.

(b) Supply side policies can be divided into market based and interventionist supply side policies. Explain the difference between these two concepts.

Market based supply side policies aim to increase the growth of AS by placing a greater emphasis on market forces and competition.

Interventionist policies aim to increase the growth of AS by placing a greater emphasis on greater intervention by governments.

Examples of market based policies include encouraging competition through deregulation and privatisation and reducing the amount of tax paid to provide greater incentives to work.

Examples of interventionist approaches include the direct provision of, for example, education and training to improve labour productivity. Other examples might be improving transport to allow workers to get to work more easily and transport goods across the country. Government incentives to encourage entrepreneurship would also fall into this category.

Activity 2

Complete the following table which provides some examples of both market and interventionist policies. Explain how each could benefit the economy but also suggest which of the supply side objectives the policy addresses.

Example of interventionist policies	Benefit to the economy
Improve the nations infrastructure, including improved transport links	When the government invests resources in large scale infrastructure projects, improving the country's roads, railways, water capacity, airports, ports and waste management facilities, the government is adding to the nations productive capacity.
Government subsidies to encourage research and development into new businesses and encourage entrepreneurship	When the government provides financial support for businesses such as energy subsidies then this increases the aggregate supply in the economy. Help for small businesses, anti competition laws and export credits also add to the long run aggregate supply in the economy.
Investment in education and training	As the government diverts resources into education and training the productivity of the workforce is improved. This is because a better educated workforce is capable of using more complex machinery and producing products of a high quality.
House building programmes	Increasing the housing stock of a nation improves labour mobility by making it easier for workers to move around the country in search of work.
Example of market based policies
Deregulation of product markets may be implemented to bring down barriers to entry, encourage new and dynamic market entrants	The effect of this would be to make markets more competitive and increase efficiency. Promoting competition is called competition policy.
Privatisation of state industries	Contribute to the spread of an enterprise culture. As long as privatisation is accompanied by measures to promote competition, there are likely to be efficiency gains for the firm, and productivity gains for the employees.
Government can encourage local rather than central pay bargaining. National pay rates rarely reflect local conditions, and reduce labour mobility	National pay rates can reduce labour mobility. For example, national pay for Postmen does not reflect the fact that in some areas they may be in short supply, while in other areas there may be surpluses. Having different rates would enable labour to move to where they are needed most.
Legislation restricting the power of trade unions in any economy.	Trade unions bargain on behalf of their members in order to raise wage levels, restrict working hours and improve working conditions. Reducing the power of trade unions, to negotiate on behalf of their members, will increase the ability of firms to produce goods and services at a lower cost.
The removal of restrictive practices in the labour market, such as employment protection	Government restrictions on working hours, minimum wage or working conditions will restrict the ability of businesses to produce goods and services. Similarly, when governments remove those restrictions then businesses will be able to increase their output levels.
Reduction in taxes	When a government reduces income taxes workers will keep a greater share of their income. The argument therefore is that when workers are allowed to keep a higher share of their earned income they will work harder to improve their household income.
Reducing corporation tax rates	Just as workers may be more incentivised to work harder if they are allowed to keep a higher proportion of their income, some businesses may also be encouraged to produce more goods and services if they are able to keep a higher proportion of the profits earned.
Reducing out of work benefits	Many governments provide a minimum living for those workers who are temporarily or sometimes even long term unemployed. This may discourage some workers from accepting a low paid position because the individual may be better off financially on benefits than being at work. In this situation, reducing or restricting out of work benefits can increase the incentive for many to find work, increasing the productive capacity in the economy.

Activity 3: Weaknesses of supply side policies

Looking at the list of supply side policies above, identify some of the weaknesses of the supply side policies identified.

Any supply side policy aimed at improving the level of training or infrastructure in the economy is both expensive to operate and also takes many years to bear fruit. Even in situations where the government correctly identifies the correct level of training or infrastructure needed it may become obsolete by the time the project is finished.

Similarly while some of the projects will be targetted effectively history is riddled with failed projects attempted by governments. For example, extensive government house building projects may end building the wrong type of houses or the correct housing type but in the wrong location, leaving the project as an expensive white elephant.

Reducing tax rates (either income or corporation taxes) comes at an opportunity cost.

Lastly, policies aimed at weakening the power of trade unions or removing employment protection or out of work benefits comes at a social cost to a society, as well as increasing wealth and income inequality.

Activity 4: Spain ghost's airport

Watch the following short video about Spain's ghost airport.

Why does this highlight the dangers of government intervention in infrastructure projects?

The video provides an excellent example of why many governments may be reluctant to invest tax payers money in infrastructure projects, when there is no guarantee of success. The question often asked 'if the private sector won't build it why should the public sector make a success out of it?'

Activity 5: What do some nations have higher productivity than others?

Start by watching this video which explains some of the reasons for this and then answer the questions that follow.

(a) According to the video why are US workers paid many times more than those in Bangladesh?

It comes down to productivity, the productivity of the USA is very high, with workers typically producing high value added products and using some of the best technology on the planet to do so.

(b) Why have the wealthiest nations been able to increase their productivity consistently over time?

The key to improved productivity is developing the factors of production e.g. human capital and technology over time and take advantage of technological breakthroughs when they come along e.g. USA productivity boomed in mid 1990s because of the invention of the internet which took capital and used it more efficiently.

(c) Which nations were singled out as having made very significant recent gains in output per worker and enjoyed greater living standards as a result?

China, Ghana, Mexico and South Korea

Activity 6: Theory of knowledge: potential connections

Investment in education and training is a common supply-side policy. What knowledge issues arise in answering the question as to whether government should shoulder this responsibility or whether it should be left to the market?

Activity 7: Link to the assessment (paper one examination)

(a) Explain why some factors of production might shift the SRAS (short-run aggregate supply) curve, but leave the LRAS (long-run aggregate supply) curve unchanged. [10 marks]

Command term: Explain

Key terms to explain: SRAS, LRAS, factors of production.

Examples of factors of production which impact only the SRAS while leaving the LRAS curve unchanged include adverse weather conditions impacting on crop harvests, oil prices or wages which might shift the SRAS curve but have no affect on a country’s long-term productive capacity (LRAS curve).

(b) Using real world examples, evaluate the view that supply-side policies are the most effective method of increasing the level of national income. [15 marks]

Command term: Evaluate

The command term asks candidates to evaluate whether demand or supply-side policies are more effective in increasing the level of national income. Candidates must consider arguments in support of this statement followed by counter arguments, followed by a suitable conclusion based on the evidence provided.

Real world examples might include a range of nations that have adopted both demand and supply side policies with varying degrees of success. For example, following the financial crisis of 2007-9, the USA economy benefited as a result of expansionary demand side policies, while Japan, over a long period adopted a series of expansionary demand side policies (through increased government spending and quantitive easing) but their economy remains stuck in a recessionary cycle - and with significant higher national debt levels as a result. Examples of nations that have used supply side policies to grow their economy's long term might include the UK and USA throughout the 1980 and 1990s.

Responses should also include the following:

A definition of national income and supply-side policies. If this has already been defined in part (a) of the response then there is no need to repeat this definition. However, candidates are required to refer to this definition at the beginning of the section, in order to gain credit for it.

A recognition that supply side policies are aimed at increasing aggregate supply (AS), a shift from left to right. They enhance the productive capacities of an economy while improving the quality and quantity of the four factors of production.

The response needs to include a discussion of how national income can rise as a result of supply-side policies, with examples of supply side policies that may be effective e.g. improvements to infrastructure, investments in human capital as well as increased spending on research and development.

This can be illustrated by an AD/AS diagram (diagram 1), illustrating a shift in the AS curve and a rise in national income from Y1 to Y2 or a PPC diagram illustrating a right shift in the PPF curve (diagram 2).

A discussion of some of the disadvantages of governments using supply-side policies, e.g. time-lags, the cost of large scale investment projects and the uncertain effectiveness of lowering taxes.

The response also needs to include a discussion of alternative policies that may be used to increase economic growth - demand side policies. A diagram representing a right shift in AD as a result of expansionary fiscal or monetary policy. Examples might include a rise in government spending or a reduction in interest rates, leading to a rise in AD and an increase in national income from Y1 to Y2. Alternatively candidates may draw a PPF diagram showing a movement towards a point closer to the PPF maximum, shown on diagram two by a rise from point A to B.

Examples of different monetary and fiscal demand-side policies which can increase either consumption, government spending, investment or net exports.

A recognition of some of the disadvantages of governments using demand-side policies to stimulate economic growth. Examples of problems that may arise as a result of using demand side policies include time-lags, inflationary pressure, increased government debt, increased imports or crowding out. It should also be noted that demand side policies are only effective when their is spare capacity in the economy. Without available unemployed resources any rise in aggregate demand is likely to be inflationary only.

Real life examples might focus on nations that have been successful in raising the productive capacity of a nation through supply side measures, as well as those that have employed demand side policies with differing levels of success e.g. USA post 2009 and Japan which remains stuck in a period of slow economic growth despite extensive stimulus demand-side measures.

A conclusion with an evaluation of the above arguments in terms of short-term versus long-term consequences and the impact on different stakeholders. This section of the essay is also suitable for students to provide their own opinions on the effectiveness of demand side policies in raising economic growth.

A suitable conclusion might be that demand side policies are straightforward to implement and are relatively effective in the short term, providing their is spare capacity in the economy. However, they do little to improve long term growth in the economy, which is best served by the implementation of supply side policies which have the ability to improve the quantity and / or quality of the available factors of production.

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